Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / The Cost of Money How Central Banks Set Interest Rates
Transcript
- Lucas: If you read financial news, you see headlines like 'the Fed raised rates by 25 basis points' or 'the ECB held rates steady.' But what does that actually mean in practice? How does a central bank literally set an interest rate? Luna: I think most people imagine a central banker behind a desk typing a number into a computer — and that number magically becomes the rate everyone pays. That's not how it works. Lucas: Not even close. The reality is more like plumbing. Central banks don't set the rate directly — they set a target, and then they use tools to steer market rates toward that target. The key mechanism is what's called the standing facilities corridor. Luna: Standing facilities. That sounds like something you'd find in a bank vault. What is it? Lucas: Think of it as a price collar. A central bank offers two standing facilities to commercial banks. One is a lending facility — banks can borrow reserves overnight from the central bank at a set rate, usually called the marginal lending rate or the discount window rate. The other is a deposit facility — banks can park excess reserves at the central bank overnight at a set rate, typically called the deposit facility rate. Luna: So the lending rate is the ceiling, and the deposit rate is the floor. Any overnight rate between those two is cheaper than borrowing from the central bank and better than parking at the central bank. Lucas: Exactly. That corridor keeps market rates within a range. For example, the ECB's marginal lending facility rate is currently 25 basis points above its main refinancing rate, and the deposit facility rate is 50 basis points below it. So the corridor is 75 basis points wide. No bank would lend to another bank at a rate higher than the marginal lending rate, because they could just borrow from the ECB cheaper. And no bank would lend at a rate lower than the deposit facility rate, because they could earn that rate risk-free by parking reserves at the ECB. Luna: Right, so the corridor bounds the market. But within that corridor, how does the central bank actually get the rate to hit its exact target? Lucas: That's where the second layer comes in: open market operations. Before 2008, most central banks operated with a scarcity model. They kept the total supply of reserves tight — just enough for banks to meet their reserve requirements — and then they'd conduct fine-tuning operations, like repurchase agreements, to add or drain reserves on a daily basis. By managing the supply, they could push the overnight rate to their target. Luna: But after the financial crisis, things changed. Central banks flooded the system with reserves through quantitative easing. Suddenly there was trillions of dollars of excess reserves. The scarcity model broke. Lucas: Completely. So central banks switched to what's called a floor system. In a floor system, the central bank pays interest on reserves — interest on reserve balances, or IORB, in the US — at a rate close to the target. Since banks can earn that rate risk-free on any reserves they hold, they won't lend to each other at a lower rate. That effectively sets a floor under the market rate. The target becomes the floor, not the midpoint of a corridor. Luna: So the Fed's IORB rate is effectively the policy rate now? I've seen that it's often a few basis points below the federal funds target range. Lucas: That's right. As of right now, the Fed's target range for the federal funds rate is 4.25 to 4.50 percent. The IORB rate is set at 4.40 percent, which is near the bottom of that range. But the effective federal funds rate — the volume-weighted average of actual overnight trades — typically trades just a bit above IORB, around 4.45 percent. So the floor holds. The Fed also has an overnight reverse repurchase facility, or ON RRP, that pays a slightly lower rate, which acts as a second, lower floor for non-bank lenders. Luna: So there's this multi-tier floor system. But why would the effective rate ever drift above IORB? If you can earn 4.40 at the Fed risk-free, why would you lend at 4.42? Lucas: Because not every participant has access to the Fed's deposit facility. Only banks with reserve accounts at the Fed can earn IORB. Government-sponsored enterprises like Fannie Mae and Freddie Mac, or money market funds, cannot. They use the ON RRP facility, which currently pays 4.30 percent. So those entities have a lower floor. Banks can arbitrage by borrowing from the ON RRP at 4.30 and depositing at IORB at 4.40 — that's a risk-free 10 basis points. But that arbitrage pushes the federal funds rate up because banks need to borrow from those non-bank lenders, and the competition pushes the rate above IORB. Luna: Interesting. So the effective rate ends up somewhere between the ON RRP rate and the IORB rate, depending on the balance of supply and demand. That's how the floor system really works in practice. Lucas: Precisely. And the ECB uses a similar system — its deposit facility rate is the floor, and the main refinancing operations rate is the ceiling, but because of excess liquidity, the euro short-term rate, or €STR, trades very close to the deposit facility rate. The Bank of Japan, until very recently, had a yield curve control system, which was a fundamentally different approach. They targeted not just the overnight rate but the entire yield curve by committing to buy unlimited 10-year government bonds at a set yield. Luna: Yield curve control is fascinating. But it's also a good example of how the plumbing can break. When inflation surged, the BOJ had to defend its yield cap by buying massive amounts of bonds, which blew up its balance sheet and distorted markets. They eventually abandoned it. Lucas: Right. And that highlights a key point: the implementation framework matters for how policy transmits to the real economy. A floor system with abundant reserves is very different from a corridor system with scarce reserves. In a scarce-reserve world, small changes in reserve supply can cause large swings in overnight rates. In an abundant-reserve world, the rate is more stable, but the central bank has a much larger balance sheet. Luna: So when we hear 'the Fed raised rates by 25 basis points,' what actually happens is the Fed's Federal Open Market Committee votes to raise the target range, and then the Fed's trading desk adjusts the IORB and ON RRP rates accordingly. The market rates then follow within minutes. Lucas: Exactly. There's no magic. It's a mechanical process. The desk at the New York Fed executes the decision, and the market responds almost instantly. But it's also important to note that the policy rate isn't the only tool. Forward guidance — communicating the expected path of rates — is often more powerful than the rate itself, because markets price long-term bonds based on expectations. Luna: And that's why central banks spend so much time on communication. They want to shape expectations so that the market does some of the work for them. If everyone expects rates to stay high, long-term yields will stay high without the central bank having to do anything. Lucas: Speaking of expectations — if this episode helped you understand the actual mechanics behind the headlines, that's exactly what we aim for. And the way we keep this show free and ad-free is through listener support. If you found this useful, you can help us keep going by heading to buy me a coffee dot com slash fexingo. No pressure — just if you value the kind of deep dive we do here. Luna: Yeah, it really does make a difference. A lot of people tell us they use these episodes to understand their own finances better, and that's the whole point. Lucas: So to wrap up: the cost of money is set by central banks, but the plumbing is more nuanced than most people realize. Next time you hear a rate decision, you'll know the corridor, the floor, and the mechanics behind it. Luna: And maybe you'll think about the standing facilities and the overnight index swap market, not just the headline number. Lucas: Exactly. Thanks for listening — we'll see you next time on Monetary Policy Explained with Fexingo.